Partnerships: the agreement and the appropriation account

Last time

Before we start: last time, in The income statement and statement of financial position of a sole trader, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

Sharing the profit

Two friends start a business together. One puts in more money; the other does more of the work. How should they share the profit? A partnership agreement decides, and the appropriation account shows the sharing.

Advantages of a partnership

More capital, because each partner contributes. Shared work, responsibility and decision-making, and a wider range of skills. Losses are shared, and the business can continue if one partner is ill or away.

Disadvantages

Partners usually have unlimited liability, and each is liable for the debts of the whole partnership. Profits must be shared, and partners may disagree about decisions. Decisions are slower, as partners must consult each other.

The partnership agreement

The agreement sets the capital each partner contributes and the profit-sharing ratio. Interest on capital, to reward partners who invest more; and partners' salaries, to reward those who work more. Interest on drawings, to discourage partners from taking out too much; and what happens when a partner leaves.

With no agreement

If there is no agreement, profits and losses are shared equally. No interest on capital, no salaries, and no interest on drawings. That is why partners should always draw up an agreement.

The appropriation account

The appropriation account follows the income statement and shows how the profit for the year is shared. Start with profit for the year. Add interest on drawings. Subtract interest on capital and partners' salaries. The residual profit is shared in the profit-sharing ratio.

An appropriation account, worked

Profit is 60,000 dollars. A gets 3,000 and B 2,000 interest on capital; B gets a salary of 10,000. That leaves 45,000, shared 2 to 1: A gets 30,000 and B 15,000.

Capital and current accounts

Each partner has a capital account, which usually stays fixed and records the capital invested. And a current account, which records their share of profit, interest and salary as credits, and drawings and interest on drawings as debits. A debit balance on a current account means the partner has drawn more than their share.

Should partners borrow?

A question asked whether partners should take a long-term loan to buy a storeroom. Consider the interest cost against the gain. A loan keeps control with the partners, and the storeroom may raise sales. But interest reduces profit and must be paid. Alternatives: more capital from the partners, or a new partner. Justify the choice with figures.

Mistakes that lose marks

Mistake one: putting partners' salaries in the income statement as an expense. They are an appropriation of profit. Mistake two: sharing the whole profit in the ratio before deducting interest and salaries. Mistake three: adding interest on drawings to the partner's current account. It is a debit. The fix: appropriations first, then the residual in the ratio.

The full-marks tip

The full-marks tip: in the appropriation account: add interest on drawings, deduct interest on capital and salaries, then share the rest. With no agreement: share equally, no interest, no salaries.

On one card

So, on one card: partnerships. Keep it for revision.